Monday, May 21, 2007

Hong Kong's Monetary Policy... continued

In my last post, I argued that HK doesn't have independent monetary policy because of the fixed exchange rate. Here I respond to the question

"Why doesn't the same argument apply to the US?"

The key difference is the exchange rate. Between HK and US, there is very little exchange rate risk. Therefore any difference in interest rates can be arbitraged by investors, at little risk to investors.

In comparison, between most currencies, exchange rate risk is high. For example, interest rates in the US are about 4% higher than Japan. That means borrowing yen to invest in the US yields approximately 0.015% in expected return per trading day. But this is trivial compared to the exchange rate risk.... according to Bloomberg, today the Yen has depreciated by 0.11% so far today already- that's an order of magnitude larger! Today the depreciation of the Yen would increase the profits of someone engaged in arbitrage. More generally, it might increase profits or wipe them out, replacing them with large losses.

The important point is that the exchange rate change is typically far larger than the interest rate differential. Investors are risk averse, so exchange rate uncertainty leads them to avoid fully arbitraging interest rate differentials.

That doesn't mean that investors aren't engaged in borrowing low interest rate currencies like the Yen to invest in higher interest rate currencies like the USD. It's called the Carry Trade- see my earlier posts here and here.

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